It's Restructuring That Will Position Nokia For Success, Not Smartphone Sales

| About: Nokia Corporation (NOK)

Nokia's (NYSE:NOK) stock has been rising significantly recently, first on reports from around the world of (disputed) strong demand and sell outs of its new Lumia 920 Windows Phone 8 smartphone -- including an announcement that it will be on China Mobile's network in December -- and then on the back of Nokia's rosy preliminary financial information for Q4 2012. However, it is not smartphone sales that will save the former darling of the mobile phone industry. What will bring it back to profitability, what will take a sick company and rebuild its foundation for the future are its restructuring efforts. Yes, it would indeed be strong smartphone sales that return it to mega-profitability, but without that solid foundation that has recently been hemorrhaging cash, Nokia will not be able to re-emerge as a strong and viable company (and long-term investment).

I previously wrote about Nokia's restructuring activities and how those efforts were positioning it well for the future. Now with the Finnish company preparing to release its full Q4 2012 results and its structural changes well underway, I'll examine how those efforts are progressing and how it is positioning Nokia for the short and long term.

While the third quarter of 2012 was, as expected, difficult for Nokia, with overall revenue dropping by EUR 300M ($399.6M) compared with the second quarter, the company did surprisingly well, with less of a loss than the previous two quarters. In Q1 2012, Nokia racked up a EUR 1.34B operating loss, followed by EUR 826M in Q2, but in Q3 the company reduced its operating loss to EUR 576M.

On the surface, it would seem that Nokia's restructuring efforts are indeed continuing to work by dramatically reducing its expenses. This payoff has come from the restructuring charges the company incurred over the last year (highlighted by EUR 873M in charges in Q1 and EUR 308M in Q2), which made up a large part of the company's losses this year. Nokia's Q3's losses were also, in large part, due to continued restructuring efforts. Its Devices & Services business unit had EUR 454M in restructuring charges and other associated items; Nokia Siemens Networks (NSN) had EUR 74M; and the Location & Commerce group had another EUR 2M, for a total of EUR 530M in Q3 2012. This shows that not only is the company reducing long-term expenses, but that much of its current losses are as a direct result of the restructuring costs.

This can also be seen in other places on the company's income sheet. In the third quarter of 2012, Nokia reported that it had net cash from operating activities of negative EUR 429 million, but that included cash outflows related to restructuring activities of approximately EUR 390 million. Meaning, Nokia was only about EUR 39M in the red on everything else in Q3 2012.

This indicates that the day-to-day operations of Nokia are surprisingly healthy (or at least not as unhealthy as the casual observer might think, or the uninformed pundit might try and make you think); especially considering how dramatically the company's overall revenue and mobile phone market share has plummeted. Consider that in Q3 of 2011, Nokia's net sales were EUR 8.98B compared to EUR 7.239 in Q3 of 2012 (an almost EUR 1.75B, or 19%, reduction). Yet, in spite of this dramatic reduction in sales, Nokia's operating profit only fell from negative EUR 71M in Q3 2011 to negative EUR 576M in the same quarter this year, a difference of only EUR 505M. So, even though revenue fell EUR 1.75B, operating profits only fell EUR 505M.

Why such a disparate drop between sales and operating loss? Because of all of the efforts Nokia has been taking to restructure itself. Since the company first announced it was going to restructure itself in April 2011, Nokia has incurred over EUR 2.4B in restructuring charges (EUR 1.4B from its Devices & Services group and EUR 1.0B from NSN), with another EUR 600M still planned. These efforts have combined to reduce Nokia's expenses dramatically.

Some of the efforts Nokia is taking to reduce its expenses are related to head-count reductions, which have occurred through lay-offs but also through sales of business units. For example, NSN announced that it will be closing its German services unit (NSN Services Gmbh), which could result in 1,000 lay-offs, all part of NSN's plan to reduce its workforce by 17,000 by the end of 2013. However, it also agreed to sell its optical fibre unit to Marlin Equity Partners, which will result in up to 1,900 employees being transferred to the new company. What should be noted though is that NSN said that these 1,900 employees are not part of the 17,000 job cuts already announced, as staff transferred through divestment are not part of NSN's targeted job cuts. This means that Nokia is not only on track to save more money by further reducing its head-count, but it will do so, in part, by raising capital through the sale of its business units, which is better than making severance pay-outs. This two-pronged approach is reflected in NSN's recent announcement to close a plant in Bruchsal, Germany, resulting in 650 lay-offs and the announced sale of a Nokia plant in Salo, Finland that had already been closed earlier this year. While both plant closures are part of the 17,000 workforce reduction, selling the Salo plant will bring much-needed capital to Nokia. This can also be seen in Nokia's recent announcement that it is laying-off 320 IT staff, while transferring 800 more employees to "strategic partners".

Nokia expects its planned restructuring of NSN to result in annual operating expenses and production overheads being reduced by EUR 1.0B by the end of 2013, and if it has more divestments, such as those mentioned above, it could further reduce that amount. It also expects its Devices & Services unit to reduce its annual operating expenses by more than EUR 1.0B in savings per year as well. Together, restructuring of these two business units could give Nokia well over EUR 2.0B in savings per year, which is a big part of the reason why Nokia exceeded its Q4 2012 outlook. Evidence of this can be seen in two key statements from the preliminary Q4 2012 results:

"Lower than expected Devices & Services' operating expenses, partially due to greater than expected cost reductions under the restructuring program."

"Better than expected improvement under Nokia Siemens Networks' restructuring program to reduce operating expenses and production overheads."

When you couple the savings from restructuring with the income from its divestments, Nokia is positioning itself well for the near and long term. For example, Q4 should see the results of the Vertu sale (potentially for EUR 200M) as well as the recent announcement that Nokia has completed its sale and lease-back of its world headquarters building, which brought in a reported EUR 170M.

Nokia's recently announced "underlying" profitability of Q4 2012, combined with the income from divestments is all looking to paint a better picture for Nokia's cash reserves too. The company ended Q3 2012 with gross cash of EUR 8.8B and net cash of EUR 3.6B. When you add in an initial EUR 50M patent settlement payment from RIM, the above mentioned sales and the EUR 750M the company raised by issuing a convertible bond in October, Nokia has dramatically strengthened its financial position and may even see a positive net cash position in Q4 2012.

I wrote in the past that it was slowness to react to a changing cell phone market that led to decreasing sales, which put Nokia into the financial situation it is in today. But it has not been slow in taking the necessary steps to right itself, and this is starting to bear fruit. Some analysts are saying that Nokia needs to sell 12 million Lumia smartphones every quarter just to break even, but that is just not true (and a claim well rebuked by a fellow Seeking Alpha author). This is because Nokia has done the difficult work of making itself a svelte company (not an easy task when you were once Europe's most valuable company), by removing what is not working and leaving it with a core that can still produce desirable, and profitable, products.

While it is not going to be smooth sailing, and Nokia has a long way to go before it has fully stabilized itself, I firmly believe it has turned the corner and is now heading in the right direction. As one reporter put it, Nokia's "ship [is] now stable, all we need is passengers". Nokia was able to make a (underlying) profit in Q4 2012 in spite of dramatically reduced revenues compared to previous years. This means the company has positioned itself to weather the poor times and reap the benefits if it can indeed find those passengers.

Disclosure: I am long NOK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.